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DISCLAIMER
By using the information within this book, you agree that it is general
educational material and you will not hold anybody responsible for loss or damages
resulting from the content provided here. Spot currency trading have large potential
rewards but also large potential risk. You must be aware of the risks and be willing to
accept them in order to invest in the futures, options or currency markets. Don’t trade
with money you can’t afford to lose. This book is neither a solicitation nor an offer to
buy/sell currencies. No representation is being made that any account will or is likely to
achieve profits or losses similar to those discussed on this website or in any of its
material. The past performances of any trading system or methodology is not necessarily
indicative of future results.
Contents
1. OUTLOOK
2. FOREX IS ABOUT PROBABILITIES
3. TREND. DEFINITION AND HOW TO DETECT IT
4. CHOOSING A TIME FRAME
5. STRONG VERSUS WEAK
6. TREND FOLLOWING INDICATORS
7. SHORT TERM MOVING AVERAGES
8. LONG TERM MOVING AVERAGES
9. RIBBON MOVING AVERAGES INDICATOR
10. GUPPY MULTIPLE MOVING AVERAGES
11. MACD
12. RELATIVE STRENGTH INDEX (RSI)
13. COMMODITY CHANNEL INDEX
14. CANDLESTICK TRADING AND PRICE PATTERNS
15. PRICE ACTION – BREAKOUTS AND VOLATILITY
16. MULTI TIME FRAME ANALYSIS
17. BOLLINGER BANDS
18. FUNDAMENTAL ANALYSIS
19. MARKET SENTIMENT – C.O.T. REPORT
20. MONEY MANAGEMENT
21. CONCLUSIONS
1. Outlook
The main objective of this book is then to guide the reader through a similar
quest for the elusive “Holy Grail” in Forex, providing everything the reader needs to
find out where the “Holy Grail” may be. There are different ways to make a profit in
forex, just as there are different opinions as to where the “Holy Grail” might be.
Different personalities, backgrounds and life experiences obviously led to different
results. In order to guide the reader along this challenging quest, the author develops a
methodology that any trader can implement, regardless of the level of experience in
trading forex.
In the search for the “Holy Grail” in Forex, an important distinction is made
between fundamental and technical analysis. Over the years, experts have debated over
which methodology might be more profitable. The first section of the book focuses on
the technical analysis and, in particular, on the investigation and the evaluation of some
classic indicators and price patterns, to verify their ability to generate profits in the
current markets. The second part focuses instead on the study of the fundamental
analysis, which is a way to predict a currency’s future performance through the study of
macroeconomic variables, such as the gross domestic product, the inflation rate, the
interest rate or the unemployment rate. Later in the book, the author explores how a
number of sophisticated trading systems perform over the time, concluding that some of
them might perform well for a currency pair, but they might be not profitable for other
ones. It is therefore essential to identify common trading rules to be applied to different
currency pairs. In the final section, the reader will learn how to manage a trade, how to
scale in or scale out and where to target the profits. This is the “Money Management”
section. Since every trade can result in a loss or in a profit, what makes a big difference
is the way a trade is managed. In general, a good trader has the ability to manage
different trades using tested and repetitive strategies, rather than predicting future
movements for every single trade. In this sense, the author shows how, poor money
management leads to final losses, even if the profitable trades are six or seven out of
ten.
What beginners will find surprising is that there is a concrete possibility to trade
the correct market direction less than fifty percent of the time, and yet to still make a
profit.
“The Holy Grail! —
… What is it?
The phantom of a cup that comes and goes?”
Alfred, Lord Tennyson
2. Forex is about probabilities
It is not easy to be consistently profitable over time. Statistics suggest that ninety
percent of the retail traders eventually lose money. Unfortunately, it is not possible to
close every trade with a profit; for this reason, many traders are tempted to close the
profitable ones too early, and leave the negative ones open, as they are unwilling to
accept a loss, hoping that they will turn to profits in a near future. This way of trading is
normally not profitable, especially if it does not take in account hedging a trade.
“Hedging” is undoubtedly an important tool in the search of the “Holy Grail” in Forex.
In fact, a good hedging enables traders to get higher profits than those resulted from a
one-direction type of trading. Further on, it is explained how a classic way of hedging
consists of triggering a long trade on a currency pair and shorting another one, when
between the two cross pairs there is a high correlation and the first pair is showing a
relative strength greater than the second. At any rate, before analyzing how hedging
works, it is appropriate to understand that Forex is a matter of probabilities. There is a
fifty percent of possibilities to be wrong or right, since a currency can move up or
down. This scenario implies two questions: How should a trader manage a profitable or
a losing trade? What is the right time to take a profit or a loss? With that in mind, it is
appropriate to stress that like in every other market, each time a trader buys or sells a
currency pair, a counterpart does exactly the opposite, so it is not advisable to become
too attached to a trade. Furthermore, every trader should always have a trading plan
before placing any kind of trade. What can make a trading plan profitable is the ability
to stop the losses while they are still small enough to be managed. Essentially, the
ability of a profitable trader is to close several positions with a small loss and to let the
winning ones run. The following hypothetical scenario might help to clarify this
concept. A trader plans to trade with $ 10.000 and to divide the amount in ten micro lots
of $ 1000 each. The trader closes seven winning trades out of ten, and accepts a profit
of fifty dollars for each winning trade and a loss of one hundred dollars for each of the
remaining three trades. Under these conditions, the result is a gain of $ 50, since the
winning trades generate $ 350, while the three losing trades lead to a loss of $ 300. If
the trader is profitable six times out of ten, however, using the same risk/rewards ratio,
the trade would generate a loss of one hundred dollars. What if the trade generates an
equal number of profitable and losing trades? The outcome is a loss of $ 250! These
examples clarify how a strategy with a risk/reward ratio of 2:1 is a losing one. It is
never recommendable to implement a trading plan using this risk/reward ratio, since it
requires being accurate most of the times. On the long run, the market would take down
the trader. It is then recommended to use at least a 1:1 risk/reward ratio. If a trader
looks for a 50 dollars of profit, the cutting point for losses should never be more than 50
dollars as well. Professional traders focus on managing their position in an appropriate
manner. They usually look for a potential profit at least twice the loss. In the
hypothetical scenario from above, and assuming an equal number of winning and losing
trades and a loss of $ 50, the outcome would be a $250 profit, proving that money
management makes the difference. In other words, what makes the difference is how a
trader handles different positions in terms of profit or loss. Next chapter illustrates what
a trend is, how to recognize it and how to exploit it for generating profitable trades.
“Avoid the Holy Grail, the heroic journeys, the pursuit of a legend--that is not
the life of the bookaneer, who must keep his eyes on the ground while other book people
live by dreaming.”
“Don't try to buy at the bottom or sell at the top” - Bernard Baruch
Chart 1. Uptrend
Chart 2. Downtrend
Having defined what a trend is, and how it can be recognized, we shall discuss
how to trade a trend. On the web, finding enthusiastic feedbacks about how to exploit a
profitable trend is quite easy. Unfortunately, some brokers try to attract clients and limit
the instructions to a couple of lessons about trends and claim that everyone can trade in
forex. However, there is a vested reason why they do it. The greater number of traders
in the market, the larger their profits. What most of people do not know is that real
trading works differently. Forex trading needs time, expertise, studies and patience.
Undoubtedly, following a trend offers the opportunity to be with the price, and
statistically there are more chances of closing a position with a profit. It is exactly like
surfing a wave or sailing: You need a strong wind. In theory, it seems easy but,
unfortunately, a trend might reverse at any time. Furthermore, while promoting
this method, some brokers often forget to point out that a trend is known only once it is
already formed, and never before. As shown above, forming an uptrend requires a
sequence of higher-highs and higher-lows, while a downtrend requires a sequence of
lower-highs and lower-lows. However, what if the price starts moving randomly?
While a trader waits for the formation of a trend, the price might suddenly change
direction, causing a loss. Since the markets are not always in trend, being profitable in
the forex is not easy. Statistics report that the markets move in trend about the 30% of
the time. This means they move in a range or in a more erratic way for the other 70%.
The next chapter will illustrate different ways of trading using trend-following systems.
“The markets are the same now as they were five or ten years ago because they
keep changing just like they did then”- Ed Seykota
Chart 4
Created with Prorealtime
Chart n. 5 gives an insight into the downtrend, originating in May 2014. A trader
should be aware that it is best to trigger only short trades, since in the opposite case, the
chances of being profitable decrease dramatically. Once again, it is important to trade
only the main current trend. However, oftentimes the trend differs for every timeframe
analyzed. In this case, a trader can analyze the daily chart, as it shows the most recent
price trend, while monitoring those price levels which can be determined from the study
of weekly and monthly charts, which may generate a trend reversal.
Chart 5
Created with Prorealtime
In any case, it is always appropriate to trade on those charts that detect a trend
clearly and where a multi time frame accordance is recognizable. Trading over shorter
timeframes is not recommended unless the trend is in accordance with the weekly or the
daily one. Essentially, a trader cannot understand what the “real main trend” is, without
looking at larger timeframes or, in other words, there is a high probability to trade
choppy prices or retracements of the overall trend. Although being profitable is not
impossible, timeframes such as five or fifteen minutes are not as reliable as the longer
ones. Over the years, traders have developed several expert advisors and performed
thousands of tests. The outcome is that different strategies, applied over short time
frames, often lead to disappointing performance. In addition, the “spread” fee retail
traders pay may cause a repricing, especially during times of increased volatility. The
next charts will illustrate other examples of downtrend or uptrends, and other cases
where a smooth trend is not recognizable.
Chart 6
Created with Metatrader 5.0
Chart 6 shows how the British Pound moved against the US Dollar over the
2014 on a daily basis: a downtrend is recognizable. It is smooth, with just one relevant
retracement in September 2014. In the specific case, traders only look for short trades,
as there are not reasons to open long trades.
Chart 7
Created with Prorealtime
The quotation just squeezed between 1.55 and 1.56, respectively the support and
the resistance threshold. This is an example of a range chart. In this scenario being
profitable is possible only following and trading each small trend inside the range,
which is extremely difficult. Not surprisingly, professionals avoid trading in this way,
as they rather wait to see where the price is going to move. Only a strong breakout,
below 1.548 or above 1.56, may be considered as a valid reason to trigger a trade in the
same direction of the breakout. The next example clarifies how it is always better to
analyze larger time frames for understanding the underlying trend. Chart n. 9 shows how
the Euro traded against the Turkish Lira on a daily time frame over the 2015. The price
moved with no direction, generating two false breakouts to the upside and downside,
respectively at 3.03 and 2.60. Above 2.90, the bulls have tried to break up the
resistance, generating a false breakout. Similarly, below 2.60, the bears have tried to
force the support with no success, causing another fake break. Therefore, it is necessary
to analyze a different timeframe to understand whether there is a long-term trend, not
visible on the daily chart.
Chart 8
Created with Metatrader 5.0
Chart 9
Created with Prorealtime
Chart 10
Created with Prorealtime
Chart 10 shows the same cross on a weekly time frame. A strong uptrend,
originated at the beginning of 2013, is now visible. In June, the bullish forces took
control of the market, pushing the price higher to form a spike at 3.20; right after that, the
bears were finally able to reject it back to 2.60. Technically, these movements formed a
price pattern similar to the engulfing bearish one. The latter is a pattern which occurs
when a large black candlestick fully engulfs the white candlestick from the period
before. It is more effective at the end of a consistent uptrend and it usually forecasts the
beginning of a downtrend in the near term. Essentially, the chart from above allows a
better understanding about the pair’s movements over the last 3 years. In fact, a trader is
now aware that an uptrend was in place for 2 years, while, after 2014, the prevailing
trend was downward. Chart 11 shows the same cross on a monthly time frame. The
reader will notice a multi-year uptrend with a spike formed in January 2014 when, as
pointed out earlier, the bearish forces pushed the quotation back to 2.60: the new
support threshold. While the weekly chart detects a pattern similar to the engulfing
bearish, the monthly one identifies a reversal pinball. It is a bearish pattern that usually
occurs at the top of an uptrend. The bulls fail to push the price higher, and the bearish
forces are then able to reject it downward. The longer is the tail of the pin ball, the
greater is the effectiveness. The pinball is followed by a Doji candle, which represents
a sign of indecision. The next candle is a black closing Marubozu, which certifies that
the bearish forces have finally taken control of the market. The uptrend is still in place;
however, the Euro is forecast to hit further highs versus the Turkish Lira, only above the
resistance.
Chart 12 shows how the US Dollar moved against the Turkish Lira on a weekly
time frame. Throughout 2012 the price moved randomly, with a relative low volatility.
On average, the Japanese candles are quite short as noticeable observing the distance
between the highs and the lows of each of them. When the volatility tends to fall under
its average, it is usually a sign that the market is having a break before the hit of a bigger
and explosive movement. This is what happened in June 2013, when a break of the
resistance at 1.90 generated a violent movement upward.
Chart 11
Created with Prorealtime
How a price moves after a breakout can be explained using the laws of physics,
and, in particular, measuring the trajectory of the price with the linear regression line.
A regression line is a straight line that attempts to predict the relationship between two
points, also known as a trend line or line of best fit. Normally when the price breaks the
resistance, the angle taken by the slope of the linear regression line becomes bigger.
However, when the angle becomes greater than sixty degrees, like at the end of the
2013, a turnaround is predictable. Essentially, the price can hardly continue to move in
such a vertical way, as if responding to the law of gravity. In our example, after the
break, inertia pushes the US Dollar higher against the Turkish Lira on the same direction
as the original one. However, when the angle of the slope of the linear regression
becomes too wide, as at the beginning of 2014, it should be expected a reversal.
Chart 12
Created with Prorealtime
Chart 13
Created with Prorealtime
Chart 14
Created with Prorealtime
Chart 15
Created with Prorealtime
Charts 16 and 17 compare the Australian and the New Zealand Dollars to the US
Dollar. In particular, chart 16 shows how the Australian Dollar moved against the US
Dollar on a daily time frame. Over the period selected, the Aussie fell steadily, with no
relevant retracements. Definitely, the relative strength of the Australian Dollar has been
significantly lower than the one of the US Dollar. In terms of percentage, the Aussie lost
17 points. Chart 17 shows the kiwi trend. In this case, the downtrend was less
pronounced if compared to the Aussie one. In terms of percentage, the variation was
approximately 13 points. The US Dollar is definitely the strongest currency over the
period selected. The British Pound is the second strongest currency, since it outperforms
against the New Zealand Dollar but loses to the Greenback. On the other hand, the
weakest currencies are the Euro and the Australian Dollar; in particular, the latter has
delivered the worst performance among the five currencies selected. This simple
analysis allows the trader to understand what currency is outperforming the others. A
smart trader is willing to open long positions on the US Dollar, once the technical
analysis suggests it might be the right time to do it.
Chart 17
Created with Prorealtime
“Okay, maybe there is no proof. Maybe the Grail is lost forever. But, Sophie, the
only thing that matters is what you believe. History shows us Jesus was an extraordinary
man, a human inspiration. That's it. That's all the evidence has ever proved. But... when
I was a boy... when I was down in that well Teabing told you about, I thought I was
going to die, Sophie. What I did, I prayed. I prayed to Jesus to keep me alive so I could
see my parents again, so I could go to school again, so I could play with my dog.
Sometimes I wonder if I wasn't alone down there. Why does it have to be
human or divine? Maybe human is divine. Why couldn't Jesus have been a father and
still be capable of all those miracles?”
Akiva Goldsman, for the film The Da Vinci Code (2006) based on The Da Vinci
Code (2003) by Dan Brown
6. Trend following indicators
“Maybe the trend is your friend for a few minutes in Chicago, but for the most
part it is rarely a way to get rich" - Jim Rogers
The most widely used indicators in trend trading are the moving averages, the
MACD and the RSI. The following chapters will examine the indicators mentioned
more in details. In particular, this chapter and the next two analyze the moving averages
and how they can be exploited to perform in trading. It will also deconstruct a series of
false beliefs which are not supported by a performance analysis. In a nutshell, the
moving averages are built to filter out the noise from erratic price movements. There are
different typologies and, when applied and tested to the real markets and to different
cross pairs, their performance differs significantly. The main types of moving averages
are the simple, the exponential and the smoothed ones. They differ in the method of
calculation. The simple moving averages are calculated giving an equivalent weight to
all the prices. The exponential moving averages, on the other hand, confer a greater
weight to the recent prices; finally, the smoothed moving averages give a lower weight
to the past prices, without removing them from the calculation. In any case, the moving
averages are tools used mainly for detecting the direction of a trend, and for finding
theoretical points of support and resistance only in part. Although a two hundreds
period moving average is generally predicted to act as a support, in case of downtrend,
and as resistance, in case of uptrend, there is no practical evidence backing such
prediction. In general, a movement does not systematically change direction after
coming in contact with a two hundred periods moving average. This theory is not
realistic, otherwise no changes of trend were possible. Changes of trend are instead a
fundamental part of trading and they occur despite the moving averages.
In addition, what type of moving average should a trader use as supports or as
resistances? Simple, exponential or weighted? As specified earlier, there are relevant
differences in the method of calculation, so that different types of moving averages
provide different levels of support and resistance. The biggest flaw in moving averages
lies then in the lack of objectivity. At their discretion, for detecting support and
resistance, some traders use a fifty or one hundred periods while others opt for the two
hundred periods. It is then appropriate to specify that supports and resistances are only
those levels of price that have shown to reject repeated attempts of break. Over the past
three decades, several trading companies along with individual traders have developed
expert advisors, based on the use of the moving averages. The results are often quite
negative and the performances vary widely, based on the type of moving averages used.
Besides, a trading system based on the moving averages can perform consistently for a
cross pair, while being at the same time unprofitable for a different one. There are no
“magic” moving averages that can predict a future movement with accuracy. The moving
averages are lagging indicators because they are based on past prices and they are thus
unable to forecast a future price movement. Moreover, the moving averages are not able
to identify the “highs” and the “lows” as they perform badly over ranging periods. For
this reason, the moving averages are predicted to work better with the stock market
where the trends are more stable. By their nature, the moving averages perform badly if
a pair has a limited fluctuation over the time. Normally, major pairs move just a few
percentage points over a week or a month. The next section will show how short and
long moving averages perform in the forex market.
“The markets are unforgiving and emotional trading always results in losses“-
Alex Elder
Emotional trading always results in losses. This is a reason why the short-term
moving averages may not be the best indicators for recognizing and riding consistent
trends. They include erratic movements which are simple noises of the market, usually
generated by the activity of the retail traders. The best way to be successful in trading is
to understand what the big players are doing. Central banks, investment banks, prime
brokers and trusts are the major players of the market. They always operate according to
a plan and never for emotional reasons. They are normally involved in operations of
carry trade and hedging against the risk of trading. In chapter 2 we already had a
glimpse at hedging, and more will be said further in the book. Now, let us explore what
carry trade is? It is a trading strategy based on borrowing a currency from a country
with low interest rate, and converting it into the currency of another country with higher
interest, possibly investing in other assets. In this sense, the activity of the big
speculators can influence the market direction of a currency, while the small traders
cannot generate directional movements to any of the pairs. The main defect of the short-
term moving averages is that they are influenced even by small price movements, what
the traders call “noise”. Since the currencies tend to fluctuate in a tight range and with
no direction, short moving averages are predicted to fail inexorably. When a price is
squeezed between a support and a resistance, the only way of being profitable is to
operate counter-trend. A trader, therefore, relies on short moving averages only when
the market is trending.
Chart 18 shows the Fiber on a daily time frame over seven months. It includes
three exponential moving averages at five, ten and fifteen periods. The exponential
moving averages are preferred to the simple ones because they give more weight to the
recent prices, thus resulting in fewer crossovers. Yet, the example clarifies how a
trading system, based on the crossover of three moving averages generates several
losing signals. Between March and April, the system has generated two buy longs and
one sell short signal that resulted in three losses. This analysis suggests why the short
moving averages cannot help a trader to be profitable. The price is oscillating between
1.06 and 1.14. The Fiber, therefore, is just moving within a range. During ranging
periods, it is never appropriate to use the moving averages, since they can perform
consistently only during trends. Essentially, all kinds of moving average fail inexorably
when a price is trading between two levels.
Chart 18
Created with Prorealtime
Chart 19 shows the EUR/USD trend on a four- hour time frame. Since a trend is
now recognizable, the use of the exponential moving averages appears to be more
proper. Not surprisingly, the trading system generates only two wrong signals. Chart 20
shows how the same trading system fails, when applied to an hourly chart. Over the
analyzed period, the Euro is getting stronger against the US Dollar, moving in a stable
uptrend. However, since the short moving averages are very close to the price, they
react quickly to the natural retracements typical of the uptrends. The outcome is that a
trading system based on the crossover of short moving averages does not generate
profits, as it results in a series of not profitable “stop and go”. In general, short moving
averages work better during sharp downtrends rather than during uptrends, since there
are fewer retracements.
Chart 21 and 22 show the Fiber trend on a daily time frame. Three simple
moving averages at ten, twenty and fifty periods indicate trading signals. Even in this
case, however, the crossover of the moving averages generates several wrong signals.
As specified, simple moving averages are less reliable than the exponential ones, as the
method of calculation assigns the same weight to all of the closing prices. In chart 22 a
rectangle highlights the uptrend. Let us see what happened, more in details.
Chart 19
Created with Prorealtime.
Chart 20
Created with Prorealtime.
Chart 21
Created with Prorealtime
Chart 22
Created with Prorealtime
Since July 2013, the Euro moved upwards against the Greenback, from 1.28 to
1.40, reaching a pick in May 2014. Over the highlighted period, it is possible to identify
at least three crossovers that generated wrong trading signals. In conclusion, since the
moving averages are lagging indicators, it is often too late to trigger a profitable trade
with them.
“To be a good trader, you need to trade with your eyes open, recognize real
trend and turns, and not waste time or energy on regrets and wishful thinking.” –
Alexandre Elder
Traders who use moving averages are aware of the dichotomy between making a
moving average as much as possible responsive to the price, and making it not too
sensitive in order to avoid entering the position prematurely. In other words, the short-
term moving averages are useful to identify changing trends before a large movement
occurs, but a system based on these indicators would open and close a position very
often because it responds too quickly to changing prices. What might happen is that the
price has already experienced a large excursion before the signal is even generated.
Long term moving averages allow the traders to avoid trading every single price
movement. They are more suitable to recognize consistent trends in comparison to short
moving averages, since they filter out the erratic movements. Typical long term moving
averages are the one hundred and the two hundred period ones. Taking from the classic
technical analysis, however, traders usually evaluate the direction of a trend on the
basis of the two hundred periods moving average. In particular, if the price is moving
above this line, it follows that the trend is up; conversely, if the price is moving under
the two hundred periods moving average, the trend is down. By logic, a trader would
then trigger respectively a long and a short trade. This approach, however, is wrong.
The correct way of using the moving averages is to evaluate their linear regression
slope: If the slope is greater than zero, then the trend is moving up; if it is negative, then
the trend is moving down. The trick lies on the possibility that the price is moving
above the two hundred periods moving average even when the linear regression slope is
negative. The classical theory would indicate the possibility to open a long position,
whereas the correct interpretation on the use of the moving averages suggests that it is
better not to do it. The classic technical analysis often uses a crossover based on a fifty
and a two hundred periods moving average. A golden cross is generated when the fifty
periods moving average crosses above the two hundred periods moving average. A
death cross is originated in the opposite case. Several studies have demonstrated that
trading systems applied to modern forex markets and based on a golden and death cross
are not performing consistently over the time. The next two charts illustrate the Fiber
trend on a daily chart. The first example shows a fifty and a two hundred periods simple
moving averages, while the second example uses the exponential ones. Clearly, the
crossover of the moving averages provides no advantage to the trader. For determining
the upward nature of the trend, it would be sufficient to see how the price moves in a
sequence of higher-highs and higher-lows. Also, as noted above, in April, the linear
regression slope of the fifty periods moving average is negative, while the price rose
above the moving average. Given the classical technical analysis, a trader could open a
long position, which unfortunately would generate a loss. Thus, opening a long trade
with a negative slope of the linear regression is never recommendable.
Chart 24 shows the golden cross. As pointed out, the exponential moving
averages usually perform better than the simple ones due to a smaller amount of
whipsaws. However, in the specific case, there are just minimal improvements of the
performance, since the crossover system does not eliminate the false signals occurring
between April and July 2014. In fact, the crossover system generated two sell signals
that would result in a loss, since the price moves in range, not showing a defined trend.
The price began moving in trend only in August. How can a trader evaluate which
crossover has the best possibilities to perform consistently? The only way is to back
test several trading systems using different typologies of crossovers. However, a back
test provides results that are related to the past, for this reason it is not guaranteed that a
same trading system will have a similar performance in the future. Furthermore, the
same system can perform well with a particular pair and perform poorly with another.
Over all, the main flaw of the moving averages is the lack of objectivity, since they do
not offer clear reference points.
Chart 23
Created with Prorealtime
Chart 24
Created with Prorealtime
“I think to be in the upper echelon of successful traders requires an innate skill, a gift.
It’s just like being a great violinist. But to be a competent trader and make money is a
skill you can learn”-Michael Marcus
Over the last three decades, traders have sought alternatives to moving averages
hoping to generate more reliable trading signals. In this sense, the Ribbon Moving
Averages and the Guppy Multiple Moving Average indicators are two variants of the
classic moving averages. In particular, the Ribbon Moving Average Indicator is a
bundle of moving averages with different period lengths, and it is made up of eight
different exponential moving averages. The shortest one is called the base length, and by
default, is set at 10. The others are based on the increment property, which is also 10. It
is then possible to change parameters, and in any case, the shorter the number of periods
selected, the more sensitive the ribbon indicator. Like the other indicators based on
moving averages, it is a trend following tool; so how to use the indicator? Basically, it
is a matter of alignments. When all the averages are aligned and they start to become
parallel, the trend is strong and the signal is reliable. When they start widening out and
separating, it means that the market is probably reaching an extreme level and the trend
may be close to its end. Conversely, when the ribbons start to converge on each other, a
trend change is already occurring. The best way to take advantage of this indicator is to
wait for the ribbon to consolidate and collapse on itself. That may often be the warning
about a possible breakout. Chart 25 shows the Fiber trend on a weekly basis, from 2011
to date. The chart includes the Ribbon indicator which correctly detected four main
trends, two up, and two down. In July 2011 and 2014, the indicator suggested a short
entry and in both cases, and the performance is brilliant. At the end of 2010, the ribbons
started to converge on each other, signaling a change of trend. The same happened in
November 2012, signaling the beginning of an uptrend. The indicator performed
consistently well because of the choice of applying it to a large time frame. Most likely,
it would not have performed in such a brilliant way if applied to a much shorter time
frame.
Chart 26 shows the Fiber trend on a daily time frame: over the 2014, the Euro
depreciated against the US Dollar and the ribbon indicator followed the downtrend,
indicating the possible points of change of trend. However, the downtrend was so strong
that the ribbons started to converge on each other only in July.
In fact, a trend is over only when all the moving averages converge on each
other and the price protrudes from the opposite side.
Chart 25
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Chart 26
Created with Prorealtime
“I think it was a step forward in my trading education when I realized at last that
when old Mr. Partridge kept on telling other customers, “Well, you know this is a bull
market!” he really meant to tell them that the big money was not in the individual
fluctuations but in the main movement- that is, not in reading the tape but in sizing up the
entire market and its trend.” – Jessie Livermore
Chart 27
Created with Prorealtime
Chart 28
Created with Prorealtime
In other words, if the price moves up strongly, bulls are closing their longs with
a profit, while bears are stopped out. In such conditions, a break of the fight should be
expected before a new strong movement may occur in a new direction. Chart 29 shows
the Euro Dollar trend on a daily basis. Over the selected period, the euro has moved in
range, between 1.06 and 1.14. In May, the two groups of moving averages started to
intersect each other, suggesting the trader to use only range bound strategies. Without a
doubt, in this scenario the recommended course of action for this currency pair is to buy
lows and to sell highs.
Chart 29
Created with Prorealtime
“One characteristic I’ve found among successful traders is that they function
effectively when they are not trading. When markets become very quiet and range
bound, they occupy themselves with a variety of activities, from sharing ideas with
peers to conducting research. Traders who do not tolerate inactivity will inevitably feel
the need to trade, often when there is no objective edge present. For them, losing money
is less onerous than experiencing boredom”. – In trader Feed
Chart 30
Created with Metatrader 5.0
Regular Divergence:
Higher highs in the price and lower highs in the oscillator. A
trend reversal is expected from up to down.
Lower lows in the price and higher lows in the oscillator. A
trend reversal from down to up is expected.
Hidden Divergence:
Lower highs in the price and higher highs in the oscillator. A
confirmation of the price trend which is down is expected.
Higher lows in the price and lower lows in the oscillator. A
confirmation of the price trend which is up is expected.
Chart 31 shows the Fiber trend on a daily time frame. Over six months, the Euro
moved from 1.06 to 1.1150, testing several times the support at 1.06 and the resistance
at 1.14. For the analysis, it will be assumed that short or long signals are triggered when
the signal line crosses above or under the MACD. From March onwards, the indicator
generated four buy and four sell signals. Back- testing the trading system, the outcome is
negative. The reason is that the price is moving in a range. Chart 32 shows how the Euro
performed against the Canadian Dollar on a weekly timeframe. Over the 2013, the Euro
gained against the Canadian Dollar, moving in a stable uptrend. In June 2013, the
MACD crosses above its signal line, thus riding a consistent trend until its end in March
2014. The histogram was above the zero giving a confirmation about the strength of the
trend. In March 2014, the MACD line crosses under its signal, signaling the beginning
of a downtrend. As mentioned, the trader can analyze even the momentum. The
histogram followed the downtrend, reaching its deepest point in July 2014. While the
price fell even more, the histogram started to converge towards the zero, warning about
a possible trend reversal.
Chart 31
Created with Prorealtime
Chart 32
Created with Prorealtime
“I believe the very best money is made at the market turns. Everyone says you
get killed trying to pick tops and bottoms and you make all your money by playing the
trend in the middle. Well for twelve years I have been missing the meat in the middle but
I have made a lot of money at tops and bottoms.”- Paul Tudor Jones
Chart 33
Created with Prorealtime
Chart 34
Created with Prorealtime
Chart 35 shows the Fiber on a daily time frame. Over the analyzed period, the
pair moved in a range between 1.05/1.06 and 1.14. In the lower section it is displayed
the RSI. Between March and April, the indicator moved into oversold after the price
tumbled from 1.14 to approximately 1.05. Bulls were then able to push the price higher
to the previous threshold at 1.14. Between May and June, the indicator made a triple
top, with the price unable to break the resistance at 1.14. The latter is the new resistance
level, while 1.06 and 1.08 are the supports. A trader is now aware that the pair is
moving in a range. Based on the rule explained in this chapter, it may be best to apply
only a range strategy. As specified, a trader should never be afraid to trade ranging
charts, since several statistics estimate that the market moves in range or in an erratic
way 70% of the time. Only if the price breaks above 1.16, the trader is then looking
forward to trade the trend, once a series of higher-highs and higher-lows is formed. In
terms of risk prevention, if the price breaks the resistance, the stop loss should be
positioned under the previous low at 1.08. In the case when the price reverses after
hitting the resistance at 1.14, a stop loss should be positioned above 1.16. Moreover,
the brokers are able to check where the stop losses are and they might be able to hit
them. For this reason, it is suggestable either to use a larger stop loss, increasing then
the risk, or to hedge trading a high correlate pair. Managing the risk involved in trading,
however, will be argument of study in the money management section.
“Rule number one: Most things will prove to be cyclical. Rule number two:
Some of the greatest opportunities for gain and loss come when other people forget rule
number one”- Howard Marks
Developed by Donald Lambert, the Commodity Channel Index is a momentum
oscillator that measures the difference between a price change and its average.
Originally created only for the commodities market, it is now widely used even in
Forex. The indicator oscillates between two thresholds marked at: + - 100. Like the
RSI, the CCI is used to identify the overbought and the oversold price areas or to
detect possible trend reversals. The indicator moves into overbought when it surges
above +100 and into oversold when it falls under -100. If the price is moving in a
strong trend, a trader can open a long trade once the indicator moves into overbought;
if, conversely, the CCI moves into oversold a trader can trigger a short trade. If the
price is moving within a range and the CCI moves into overbought, a trader can open a
short trade, while when the indicator moves into oversold, a trader can trigger a long
position. A second way to use the CCI is to trade when the indicator crosses over the
“zero” line. More specifically, if the indicator moves back from the overbought area
and it crosses over the zero line, a trader should only look for short trades, whereas in
the opposite case a trader should be looking for long trades. Like the RSI, even the
CCI can be used to detect a divergence, providing a warning about a potential
reversal, since the momentum is not confirming the price action. A bullish divergence
is formed when the price makes a lower low, while the indicator makes a higher low,
indicating a smaller down-ward momentum. A bearish divergence occurs when the
price hits a higher high while the CCI hits a lower high, which indicates a smaller
upside momentum. A trader should always be aware that divergences can be
misleading in a strong trend. In fact, when the price is moving in one direction
strongly, it is possible to see several bearish divergences before the price hits a high.
The indicator can be also used to identify price cycles. A cycle can be defined as a
repetition of a movement on a regular basis. Cycles are not only object of financial
study, since cyclical phenomena normally occur in nature (such as the phases of the
moon, or more marked turning of the seasons above and below certain latitudes). Let
us see what characterizes a cycle. Firstly, lows are normally used to define a cycle’s
length and to forecast future cycle lows. However, it might happen that a low may not
appear in strong uptrends. Similarly, a high may not be seen during strong declines.
Secondly, the cycles are often not identical since, they differ in amplitude and length,
and can even disappear at times. Thirdly, during bull markets, prices peak in the latter
part of the cycle. Conversely, during bear markets, prices usually peak in the front half
of the cycle. The cycle analysis is used by traders to identify turning points. Simply
put, traders should analyze trends to establish direction and cycles to anticipate turning
points.
Chart 36
Created with Prorealtime
Chart 36 shows the Fiber, on 1hr time-frame. For this analysis, we can use the
same chart used to explain how the RSI works. The choice is not casual. The purpose is
to study whether the two indicators provide similar trading information. However, the
CCI generates a larger number of whipsaws than RSI. In other words, it oscillates more
than the RSI. On the 19th a long white candle is a signal that bulls are trying to push the
quotation higher. With the CCI bullish signal in force along with the white Marubozu,
focus will be only on bullish setups. Even on the 14th, the indicator generated a bullish
signal, which it should not be followed since the volatility is compressed and there is
no a long white candle which might think about a breakout. With regards to the study of
cycles, it is not possible to accurately identify the duration, since the hourly chart
displays a price that moves erratically from 14th to 19th. Therefore, in order to evaluate
the price cycle, it is appropriate to analyze larger time-frame charts.
Chart 37
Created with Prorealtime
Chart 37 shows the price trend on 4h time-frame chart. In this example, the
indicator shows more accurate signals than the ones shown on 1hr chart. In particular,
between July 30th and August 5th, two lows are observed. The first low should be then
evaluated as a false end-point of the descending cycle, because the cycle actually ends
on August 5th. From this date onwards, a new cycle starts, with a high on August 13th
and with the cycle ending between the 18th and 19th of August when the indicator
reaches a new low. Again, from this point on, a new cycle is formed, with a new high in
conjunction with the break-up of the previous one. The daily chart shows cycles of
about a month and a half. In particular, chart 38 shows five cycles. In every cases the
indicator hits a low roughly every month and a half. Only the last cycle, the one formed
between late May and mid-July, has a slightly greater length. The last cycle hits a
double bottom with the price quoting first at 1.10 and then at 1.08. This can create some
trouble to a trader, since it is difficult to predict a low with accuracy. The monthly chart
(shown in chart 39) perfectly illustrates alternating cycles. The first cyclical price low
is identified in mid-2010, while between 2012 and 2013 the indicator suggests the
beginning of a second cycle. At the beginning of 2015, the indicator identifies a new
low which can be considered to be the beginning of a third cycle. As a matter of fact, in
2015 the indicator moved back from the oversold threshold, thus suggesting a possible
rise of the Euro against the US Dollar.
Chart 38
Created with Prorealtime
Chart 39
Created with Prorealtime
The analysis of the cycles of the last six years thus suggests that a cycle is
formed every 2 years. The cycles are not exactly the same; in fact, the last cycle lasted
longer than the previous. A better indication on the analysis of cycles could be obtained
using data from the past 15 years. In this way the presence and the average duration of
cycles is more easily discernable.
“Your ultimate success or failure will depend on your ability to ignore the
worries of the world long enough to allow your investments to succeed.”- Peter Lynch
Candlesticks trading
None of the analyzed indicator can guarantee the trader to be profitable over
time. The reason is that all of them are discretionary; in other words, they lack
objectivity. Yet, many authors and brokers advertise different trading systems based on
such indicators claiming that they are almost infallible and forecasting successful
operations to the naïve and unexperienced traders. This lack of ethics does not lead to
learn what really works in trading, but only to sales of books and software. Without a
doubt, a trader needs additional tools to trade with greater objectivity. For this reason,
it is time to see how a trader can benefit from the study of the different typologies of
Japanese candlesticks and price patterns. The Japanese candlesticks are real time
indicators of the markets’ emotions, (fear and greed). The Japanese used the
candlesticks to trade rice in the 17th century and much of development is credited to a
legendary rice trader named Homma. The candlestick trading is based on the assumption
that all of the known information is reflected in the price and that buyers and sellers
trade on expectations and emotions. The candlesticks are composed of two parts: the
body and the shadow. By definition, when the “close” is higher than the “open”, the
candlestick is bullish, while, on the opposite case, the candlestick is bearish. The
“high” is the maximum price and the “low” is the minimum price during the formation of
the candlesticks.
Here follow the most effective types of candlesticks and price patterns.
1. Marubozu candlesticks
2. Doji
A Doji is a candlestick with the same “open” and “close”. These candlesticks
have neither body nor color, since bulls and bears are balanced and they are signals of
indecision and uncertainty. How to trade a Doji? In trading with a Doji, whether holding
a profitable position or willing to open a new trade, it is always better to wait and to
see what the next price direction might be. There are different types of Doji
candlesticks.
The Rickshaw Man is a strong signal of indecision. It can appear at the end of
an uptrend, or in the middle or at the end of a downtrend.
The Gravestone Doji appears at the top of an uptrend. It is usually a warning
signal and it is appropriate to wait for the next candlesticks as a reversal is possible.
The Inverted Gravestone or Dragonfly is a Doji candlestick that can appear at
the bottom of the market.
4. Shooting Star
The Shooting Star typically appears at the top of an uptrend. It indicates that
bulls have failed to push the price higher, and that the bears were able to reject it back.
PRICE PATTERNS
5. Engulfing Pattern
The Engulfing Pattern is a high probability reversal signal. The Engulfing Pattern
consists of two candlesticks with different colors. The body of the second candlestick
completely engulfs the body of the first one. The Engulfing pattern is even more
effective when the second candlestick has a long body and it can engulf more than one
candlestick.
It is another bearish reversal price pattern that is usually found at the top of an
uptrend. It is made of two candlesticks. It originates when the second candlestick opens
above the high of the first candlestick, and it closes below the mid-point between the
open and the close of the previous day.
7. Piercing Line
The Piercing Line is the opposite of the Dark Cloud Cover. In this case, the
second candlestick opens below the low of the first one and it closes between the open
and the close of the previous candlestick. The meaning of this pattern is that the bearish
forces tried to push lower the price, with a break below the low of the first candle.
However, the bulls were able to push back the price above the low of the first candle.
8. Harami
A sequence of two candlesticks can also forms an Harami Pattern. The bigger
candlestick engulfs the whole body of the smaller one. The bigger the difference
between the length of two candlesticks is, the more effective the signal. In some cases, a
Harami pattern may represent a reversal signal, but it should always be confirmed by
the next candlesticks, since it is not as reliable as the dark cloud cover or the piercing
line.
9. Morning and Evening Star
The following price patterns are derived by the geometric analysis. In particular,
the most commonly patterns are shown. Flags, pennants, ascending, descending and
symmetrical triangles are important tools which cannot be ignored by any trader and
they usually generate a very good chance of profitability. The graphical representation
from below allows the trader to understand how to trade. It is important that the trader
follows the break of the price, placing a trade in favor of the trend.
The example from below shows two symmetrical triangles. It shows how the
Greenback moved against the Canadian dollar on a weekly basis. Over 2013, the Us
Dollar got stronger, moving from 0.96 to 1.10. Once the price breaks up the resistance
of the first triangle, it is visible a strong movement upward from 1.16 to 1.28 in almost a
vertical way. A second triangle is then formed, and the break at 1.26 is such a strong one
to push the price until 1.46. A trader should always trade the price action and learn to
identify the geometric patterns shown above. Hereafter, are shown three examples of
price action.
11. Parabolic Curve
Chart 40
Created with Prorealtime
Chart 40 shows how the Euro moved against the Turkish Lira on a weekly basis.
It is a nice example of a parabolic curve. Since August 2012, the pair moved in a strong
uptrend, in a smooth sequence of higher–highs and higher-lows. Notably, between the
end of 2013 and the beginning of 2014, the price linear regression became almost
vertical in association with candlesticks of increased amplitude. When the linear
regression assumes such an angle, what happens is that the big players are taking profits,
while retail traders are entering in the market late, only to be then stopped out. It is thus
recommended to never get long positions when the linear regression is almost vertical.
It is normally too late for being profitable. In fact, at the beginning of the 2014, a bearish
candlestick with a long tail fully engulfs the previous long white candle, indicating that
the uptrend is over.
Chart 41
Created with Prorealtime
Volatility is a rate at which the price of a cross pair increases or decreases for a
given set of returns. By definition, volatility is high when a large price movement occurs
within a short amount of time. Conversely, volatility is low when a little movement
occurs in a short period of time. So, how can volatility be exploited? Ideally, a trader
should trade those pairs that are moving next to some relevant resistance or support
level.
If the price is trading near a threshold and it is testing it several times, it may be
a sign that a breakout is next to occur soon. A trader should then be ready to trade on the
same direction of the breakout once it occurs and the volatility skyrockets. There are
two main ways to measure the volatility: the Bollinger Bands or the Average True
Range (ATR). The ATR measures the average trading range of the market for X amount
of time. For instance, if the ATR is set to 20 on a daily chart, it shows the average
trading range for the past twenty days. When the ATR is falling, the volatility is
decreasing. When the ATR is rising, the volatility is increasing. Breakouts and volatility
work in association. A volatility increase is necessary to generate a breakout. Fake
breakouts in general occur when volatility is not strongly increasing. Let’s now see a
few examples of breakouts.
Chart 43 shows the Us Dollar versus the Swiss Franc on a daily time frame. For
the first half of 2014, the pair moved between 0.875 and 0.915. In September, a white
Marubozu candle breaks above the 0.9150 threshold. Breakout is strong enough to push
the price higher until the parity at the end of 2014. Horizontal breakouts are excellent
patterns for making profits. However, not all of the breakouts are valid to trigger a
trade, since resistances and supports are fighting levels for bulls and bears.
Chart 43
Created with Metatrader 5.0
How is then possible to avoid fake signals? The Following signs may help to
recognize a valid breakout.
1. The price has previously tested the resistance or the support levels
several times, but in association with a low volatility.
2. A long white or a black candle breaks the resistance or the support.
3. A strong increase in volatility.
4. A second or a third candle breaks the high or the low of the first one.
A long trade is then triggered once the next candle breaks above the high of the
one which broke the resistance. Shorts are triggered on the next candle which is closing
below the low of the one which broke the support. It is then recommended to not take in
profits, until the price hits a resistance or a support, recognizable by analyzing a larger
timeframe. Ideally, when trading a breakout on a daily chart, it is appropriate to close it,
once the price hits a resistance or a support threshold, detectable on a weekly chart.
Some traders, on the other hand, prefer closing trades using Fibonacci extensions.
Chart 44 shows a different example of a horizontal breakout on a DKK/NOK
cross. A horizontal white line underlines the resistance at 1.14. Over the whole 2013,
the Danish Koruna got stronger, generating an uptrend that found a relevant resistance at
1.14. This threshold was tested five times throughout 2014. In November, the bullish
forces were finally able to overcome the resistance of the bears, originating an
outstanding and almost vertical movement upward, which delivered a sensational profit
in just a month. While there are no magic indicators, price action works!
Chart 45 shows how the Euro moved against the Norwegian Krone on a weekly
timeframe. In 2014, the price has tested several times the resistance at 8.5. Finally, in
November, bulls were able to push the price higher. The box highlights the long white
candle that breaks the resistance at 8.50. Once it broke this resistance, the Euro gained
about 16 % against the Norwegian Krone in a few days. The breakout generated an
explosive movement associated with an increase in volatility. Worth noting, is the very
long bearish pin ball, which indicates that the bulls have exhausted their driving force
and that the bearish forces are now in control of the market, as they are able to reject the
price back to the former resistance - now a support - at 8.50. Traders should always
know how to trade high volatility movements, because they provide an excellent
opportunity to make profits. However, statistics suggest that the retail traders are usually
not profitable during the most volatile time of the day. This happens because traders do
not know what kind of strategy can be the most profitable based on the time of the day. A
relevant difference between the retail and the professional traders is that the latter
usually filter trades, applying different strategies at different time of the day.
In other words, applying a breakout strategy to a non- volatile market time is not
profitable, while a range-trading strategy does not perform during the most volatile
times.
Chart 44
Created with Prorealtime
Chart 45
Created with Prorealtime
Forex trading is highly affected by which markets are open. For instance, the
EUR/USD is the most liquid cross and its volatility reaches the pick when both New
York and London are open. The same concept applies for the GBP/USD and USD/CHF.
The USD/JPY is volatile at the start of the Tokyo and New York sessions, while the
Aussie and Kiwi volatility increases when Tokyo overlaps Sydney.
The following tables illustrate the dynamics that exist among several markets:
GBP/USD
- Hourly Volatility (Pips/GMT Hours) Source: Investing.com
Like in the Fiber case, even the Cable is more volatile between 7 am and 8 am
and between 12 am to 3 pm, moving from 25 up to 40 pips per hour. A substantial
difference is evident with the Asian currencies as the NZD/JPY. By virtue of the time
zone, in fact, the Asian currencies report the highest peaks of volatility during the
European night.
NZD/JPY -
Daily Volatility (In Pips) Source: Investing.com
NZD/JPY - Hourly Volatility (Pips/GMT Hours)
Source: Investing.com
A difference verifiable in relation to the Fiber and Cable is that the average hourly
variation is almost constant during the day. During the reporting period the variation is
between 20 and 30 pips.
Jarod Kintz
16. Multi Time Frame Analysis
“The goal of a successful trader is to make the best trades. Money is secondary.”
-
Alexander Elder
Traders can analyze multiple time frames to get deeper information for their
analysis. In other words, a trader identifies the overall trend on the highest time frame
and then set up the entry on the lowest one. The goal is to consider the overall market
direction analyzing the longest term chart. A trader, then, can use the shortest time frame
to enter a trade once the same trend it is detected. For instance, while the weekly and
the daily charts are useful as an overviews on the underlying trend, the four hours and
the one hour charts may be used to set up the entries. The charts from below show how
the Greenback moved against the Norwegian Krone in four different time frames. Both
the weekly and the daily charts show how the US Dollar is stronger than the Norwegian
Krone. In particular, chart 46 shows how the price was moving slightly higher in 2014,
finding a horizontal resistance at 6.30. The following break out of the resistance has
projected the price to the current level at 8.40.
Chart 46 - Created with Prorealtime
Chart 47 shows the pair trend on a daily time frame. Again, we can see a smooth
uptrend with a formation of a series of higher-highs and higher-lows. The uptrend is
then clearly visible on both the long-term charts. As a result, by analyzing the four and
the one-hour time-frame charts, a trader should only trigger long positions, since they
have a greater chance of being profitable and they can provide a greater number of pips
than the short positions. However, how can a trader open a position analyzing the four-
hour and the one- hour time-frame charts? This is a discretionary choice, since it
possible to evaluate different alternatives. Using the analyzed indicators, a trader could
open a long trade once the RSI or the CCI move into an overbought area, or more
simply, when the chart shows breakouts. In the last scenario, the long trades are opened
when the price breaks out the resistance, identified on the four hours or on the one- hour
time-frame charts.
Chart 47
Created with Prorealtime
Looking at the four-hours chart, various entry points are conceivable. The first is
indicated by a long white candle, whose body shows an increased volatility, between
the 22th and 23rd of October. A second hypothetical entry signal is generated between the
26th and 28th of the same month, after the formation of a small horizontal resistance. The
price broke such a resistance before retesting it, eventually continuing to move upwards.
Between the 4th and 5th of November, the chart shows a new break to the upside, which
has been proven to be a fake signal, since a long black candle subsequently pushed the
price downward. A decisive upward signal, instead, was generated on November the
7th.
Chart 48
Created with Prorealtime
Analyzing the one-hour chart, the entry signals are less clear, even though the price
moved upward.
Chart 49
Created with Prorealtime
Increasing the chances of trading the correct side of the market is not the only
reason why a trader should analyze different time frames. This methodology, in fact,
reduces the risk, since it is possible to place tight stop losses. For instance, trading a
weekly chart, retail traders may not afford to place a stop loss under a low in an
uptrend. Considering the weekly chart of the example, a logical stop loss would be
placed under the low at 7.30. In a four hours and one- hour time-frame charts, instead,
the stop loss would be placed respectively at 8.40 and at 8.55. It is a big improvement
in terms of risk prevention. Obviously, placing a stop loss below a low in a weekly
chart reduces the possibility of being stopped out, since in case of retracement, the price
would have more room to resume the uptrend. However, if the trend changes direction,
setting a stop loss in a weekly time-frame chart would lead to a significant loss.
Let us now apply a multi time frame analysis to the AUD/NZD cross. The
specific example will show how different the trends are. Chart 50 shows how the cross
pair moved on one- hour time-frame chart. Clearly, it shows an uptrend, as the
Australian Dollar got stronger against the New Zealand Dollar, moving from 1.0580 to
almost 1.09. The study of this chart might induce the trader to open a long trade.
Chart 50
Created with Prorealtime
So, if we extend the time horizon and have a look at the four- hour time-frame
chart, shown in chart 51, we see that this chart provides the same indication. Between
the 11th and 17th of February, the Australian Dollar appreciated against the New
Zealand Dollar. During the following days, the uptrend has undergone through a short
phase of retracing, which cannot be considered as a downtrend. So far, the two charts
have shown the same trend. The trader could then be tempted to open a long trade at the
break of the high at 1.09.
Chart 51
Created with Prorealtime
The analysis of the daily chart can help the trader to verify if the overall trend is
moving upward as well. The trader would then acquire a greater confidence about the
real trend. However, the daily chart shows a great uncertainty. In fact, From May to July,
the Australian Dollar appreciated sharply against the New Zealand Dollar; after that it
began to move downward. Over a year, the pair oscillated from the parity to 1.18,
quoting now in the middle of the range. The trend is not clear, and triggering a long trade
would be then risky. In order to better understand the overall trend, it is then necessary
to analyze the weekly chart. It finally clarifies what the main trend during the past few
years was. What chart 53 shows is surprising. The underlying trend is downward. The
uptrend, which occurred between May and July 2015, was just a retracement of the
prevailing long-term downtrend. In other words, a trader who has triggered a long trade,
based on the analysis of the two short time frames chart, has traded against the main
trend. Obviously, it is possible to generate a profit only when the trade is performed at
the right time; on the other hand, if the timing is wrong, the result would be a loss.
Chart 52
Created with Prorealtime
Chart 53
Created with Prorealtime
In conclusion, while the analysis of lower time-frame charts detected an uptrend,
the one of the weekly chart detected a downtrend. In this case, it is highly recommended
not to trade this pair cross, and to look for one that shows a same trend on different time
frames.
The choice of analyzing these time-frame charts is not accidental. For instance,
comparing a 30- minutes chart with a 1-hour chart, would make no sense, because the
time periods are similar, and they would thus provide the same indications. Similarly, it
makes no sense to compare a daily time-frame chart with a one-minute time frame chart,
since the indications would be too different. The suggestion is thus to use a ratio of 1:4
or 1:6 between the trend and the entry chart.
Chart 54
Created with Prorealtime
This is the easiest way to trade with the Bollinger Bands. Chart 56, on the other
hand, shows three examples of fake breakouts. This example shows how a trader should
not follow a breakout strategy but rather apply a range trading strategy. The bands are
far from each other and the Japanese candlesticks have long bodies. As stressed out in a
previous chapter, in order to have a price explosion, it is always necessary to see a
period of a low volatility. Given that the volatility is high, the best way to trade is
undoubtedly to buy lows and sell highs.
The following tables show how the daily average variations are extremely
limited in Forex. This implies the adoption of different strategies, when compared to
stock market. In fact, while in the stock market daily changes of several points are very
common, in the currency market they are very rare and they are normally limited to a
few points over a month or a year. The tables show that the Euro has lost 25 points
against the US Dollar over one year; 13 over six months and 8 over one month.
Expanding the time horizon to three years, the loss amounted to 20 points.
Chart 55
Created with Prorealtime
Chart 56
Created with Prorealtime
These data suggest the trader that, while it is always important to trade the
correct part of the market, opening counter trend trades at the right moment is not a
wrong choice. In the specific example from below, the US Dollar has shown to be the
strongest currency and to register the best performance against the Norwegian and the
Swedish Krone. The variation against them was approximately of 37 points over one
year.
It is now time to back test four different trading systems based on the analyzed
indicators, such as the moving averages, the MACD, and the Bollinger Bands. The first
one is based on the Bollinger Bands, the second has been developed using the MACD
indicator; the third one, called “Kamast brevissime“, is based on a particular kind of
moving averages, the so called Kama moving averages. The last one was created using
a price oscillator and adopting a take profit. The back test is applied on EUR/USD and
over a period of nine years. The four trading systems are tested using a capital of
$10,000, with no reinvestment of the profits, and trading only one lot per time. No stop
losses have been used and all the trades have been closed reversing the position. The
reader should be aware that, as with other back tests based on past data, the results are
not indicative of an equal future performance. Let us now analyze how the first trading
system performed. The expert advisor is back tested on a daily chart, and it is based
exclusively on the Bollinger Bands. No other filters were added in order to verify the
effectiveness of the indicator and the outcome is positive. More in detail, the system is
profitable in 38.22 % of the trades. It generated 157 trades, of which 67 are winners
and 95 losers. The maximum drawdown is of 24.190 dollars against a maximum run up
of 64.110 dollars.
Chart 57
Created with Prorealtime
Chart 58
Created with Prorealtime
The average profit per trade is 3274.83 dollars against an average loss of $1532.78.
The trading system is therefore successful, as the profit/loss ratio is 1.32. Over the
analyzed period, the expert advisor has generated a return of + 478 %, with a final
profit of $47.810. As mentioned at the beginning of the book, the best way to make
profits is not to take the profits too soon and to let them run as much as possible. In this
sense, although the expert advisor is winning less than 4 times out of 10, it is yet
profitable, since the winning trades guarantee an average gain much higher than the
average loss.
Chart 59
Data with Prorealtime
Chart 60
Created with Prorealtime
The trading system based on the use of the MACD has generated a loss of 3480
dollars. The profit/loss ratio is equal to 0.97. The system delivered 49 profitable trades
against 82 losing trades. The maximum drawdown is 29740 dollars against a maximum
run up of 28190 dollars. The equity curve displayed in the upper section of chart 57
shows a random movement, suggesting that the MACD has performed poorly. Over all,
the result is a loss of $ 3480. The "kamast brevissime" expert advisor was developed
using a particular kind of moving averages, the so called Kama moving averages.
Developed by Perry Kaufman, the indicator is calculated using a volatility ratio. The
great advantage of the kama system is that it generates fewer fake signals in comparison
to the classic moving averages. The trading system has performed better than the
previous one with a max drawdown of 17.100 dollars against a max run up of 126.170
dollars. The profit/loss ratio is 3.17 and the number of profitable trades is higher than
the number of losing trades. In fact, the total amount of trades generated is 41, with 22
winners and 19 losers. The final result is a profit of 102.320$, or a + 1023.20%. Chart
64 shows the results of a trading system based on a price oscillator with a take profit.
Over all, this trading system generated a good result. Yet, it is appropriate to mention
the high discretion in the calculation of the take profit, since the results vary
considerably on the basis of the percentage of profit that has been set. Obviously the use
of a take profit increased the percentage of the winning trades. The profit/loss ratio
increased significantly being equal to 2.82. In other words, the gross profits are almost
3 times the losses. The maximum drawdown is of 27.460 dollars against a max run up of
81770 dollars. Over all, the system has gained a 665 %, realizing a profit of 65.650$.
Chart 61
Created with Prorealtime
Chart 62
Created with Prorealtime
Chart 63
Created with Prorealtime
Chart 64
Created with Prorealtime
“The market does not know if you are long or short and could not care less. You
are the only one emotionally involved with your position. The market is just reacting to
supply and demand and if you are cheering it one way, there is always somebody else
cheering it just as hard that it will go the other way”-Marty Schwartz
Technical analysts try to forecast how a currency might move in the future
through the analysis of past data. Fundamentalists, on the other hand, look at macro-
economic data-sets to achieve the same purpose, believing that the economic and the
political changes of a nation can generate considerable variations on the underlying
currency. The Growth Domestic Product, the Inflation Rate and some other estimations
all have a strong impact on the underlying currency, generating large fluctuations which
may move the currency towards a new balance. Central Bankers focus on the most
important data for a nation’s economy in order to evaluate where and if moving the base
rate, with inflation and employment two of the most studied data-sets, both by the
central bankers and the forex traders. When the unemployment statistics are released,
traders will price it with a probability of a possible rate hike or a cut by Central
Bankers. When the inflation data is released, traders will incorporate it into prices,
while Central Bankers will monitor the statistics to decide what action they might be
taking at the next meeting. Normally, growing unemployment and decreasing inflation
can induce the Central Bankers to consider a rate cut. Over time, new statistical
methods have been devised to anticipate changes to inflation, unemployment and interest
rates. In particular, the consumer statistics are important since they provide an insight
into the real economy. Since the consumer activity is considered as a precursor to
inflation and growth, these data is analyzed by traders very carefully. A higher degree of
volatility can be observed around the time of the release of Consumer Sentiment
Numbers. Moreover, traders focus on production numbers, even more so lately, when it
comes to emerging economies, propelling the global growth. China is the main example.
The ‘PMI’ (Purchasing Managers Index), which is released every month, drives a global
interest among investors. The Purchasing Managers Index is the result of a survey
recorded among producers, which express their sentiment on future orders. So, if the
producers are receiving more orders than expected, it is more likely the economic cycle
is improving; while if the producers are receiving fewer orders than expected, that
might point towards an upcoming contraction in the economic cycle. Below, we will
study the most important fundamental variables more in depth.
The tables below illustrate the most important indicators for eighteen countries.
Unemployment Rate
Interest Rate
Inflation Rate
Traders wanting to know how the major market players are positioned can
analyze the open interest in the futures’ and the options’ markets. The open interest refers
to the number of contracts entered and not yet offset. In particular, the open interest
increases by one unit when a new buyer enters in the market a new purchase order and a
seller a new sell order. It is important to specify that when a buyer purchases from a
previous buyer who intends to sell, there is no increase in the open interest. The open
interest data are updated by the commitment of traders (C.O.T.) on a weekly basis. They
report the open interest for the currencies where twenty or more traders hold positions
exceeding a given threshold. Furthermore, the report makes a relevant distinction
between commercials and non-commercials positions. For the most part, the
commercials are the producers, while the non-commercials are the large speculators.
The question arises on how can retail traders benefit from the information contained in
the Cot report. Firstly, a growing open interest should be read as a confirmation of the
trend in progress, whereas a decrease is a warning for a trend which might be close to
its end. As shown in the charts below, the commercials are always on the opposite side
of the market except when the trend is nearing its end. Conversely, being trend
followers, the large speculators trade the correct side of market, with the exception of
when trend is at the end.
Therefore, when large traders are net long and small traders are net short, the
market is bullish and a trader should only look to open long trades. The larger the
relative net short position of the small traders, the stronger is the bullish trend.
However, if the two-week trend in the large trader position is moving down, or in other
words, if the large trades are closing their net long position, a trader should liquidate all
long positions as well, since this is a warning sign that the trend may be close to its end.
Conversely, if large traders are holding a net short position with small trader net long,
the market is bearish. The larger the relative long position of the small traders, the
stronger is the bearish trend. However, if the two-week trend in the large trader position
is moving up or, in other words, if the large trades are closing their net short position, a
trader should liquidate all short positions as well. These rules are generally valid, but it
is always appropriate to monitor the market constantly, since it might happen that retail
traders can hit the correct direction of the market, as it happened with T-bonds markets
recently. It is also appropriate that the COT report including both futures and options
confirm the futures only report. Chart 65 shows how the Australian Dollar moved
against the US Dollar over three years. The couple tumbled from 1.05 to 0.70. The chart
shows six macro trends. In particular, during 2012 and along 2013, the pair moved in
range between 0.95 and 1.05. During this period, the large traders were long with the
exception of the beginning of summer 2012, when they have temporarily reversed their
longs, opening short trades. However, the commercials were extremely short with the
exception of the aforementioned period. It is interesting to see what happened in August
2013, when the large traders closed their longs to reverse into short positions.
Technically, the pair found a support at 0.95. The trend changed definitively with the
break out of the support at 0.95. When large traders reverse their positions, this may be
a signal that the trend could change soon and it may be close to its end. In fact, the large
traders have the tendency to add long positions in a bullish trend or to add short
positions in a bearish trend, generating a bullish or a bearish sentiment extreme. What
happened is that the pair retested the former support - with a resistance at 0.95, to then
continue to move down. With the exception of the spring and summer 2014, the trend
was definitely oriented downward. It is important to note that traders should always
keep attention to the extreme thresholds. In other words, when large traders and
commercials hold extremely far positions, a short-term trend change is to be expected.
From a technical standpoint, what happens is that the profitable traders close their
positions in a profit, while even the last traders, which were holding a losing position,
are stopped. Chart 66 shows the Fiber trend over a year. The pair depreciated from 1.20
until 1.06. The large speculators perfectly followed the downtrend of the pair. A first
extreme is detected in early January when the large traders and the commercials have
found themselves on extreme opposite ends. This coincided with a timid bounce.
However, the downtrend continued until March. From March onwards, the large traders
have reversed their short positions, starting to buy Euros against Us Dollars. From a
technical viewpoint, between March and April, a small double bottom was formed,
from which the price then bounced. From May until November, the large speculators
held long positions while commercials reversed the position becoming net short. In that
phase, the Fiber moved in a range. Neither of the two forces was capable to overcome
the other one. A further reversal of the positions occurred in November, when large
speculators reversed their positions becoming short on the pair. Chart 67 shows the
evolution of the cable over the course of two years. Three macro trends are detectable,
perfectly followed by the positions of large traders. The first uptrend ended between
July and August 2014, when the large traders reversed their positions becoming net
short. The movement downwards lasted until May 2015, when the large trader again
reversed their positions becoming net long.
Chart 65 - Source: Timingcharts.com
“I am more concerned about controlling the downside. Learn to take the losses.
The most important thing about making money is not to let your losses get out of hand”-
Marty Schwartz
One of the main reason why the retail traders lose money is that they do not
always use the appropriate money-management techniques. As it was explained in
chapter one, the way a trade is managed accounts for a great deal of any profits. The
main difference between professionals and retail traders is that the first cut their losses
quickly, while the retails traders tend to do the opposite, cutting winners short and
letting losing trades run out of control. The ability to make profits and close the losing
trades is not the only key difference between the two categories of traders. For example,
while the professional traders only use a small portion of their accounts per single
trade, the retail traders usually trade a larger portion of their accounts. Professional
traders usually do not use more than 2% of the entire capital per trade. Statistics suggest
that the retail traders tend to use instead a much bigger size per trade. Since brokers
allow them to use the leverage, they are encouraged to open large size trades, using a
relatively small capital. However, the higher is the leverage used, the larger are the
potential losses. In other words, the retail traders are risking more than they might be
able to afford. An in depth, a study conducted by a main broker revealed that retail
traders have the best chance of being profitable after 1 year of trading, when using a
leverage ratio of 5:1 or smaller. A 5:1 leverage ratio means that a trader can open a
position for $ 50.000, using $ 10.000. The same research demonstrated that the
possibilities of being profitable in one year, decrease dramatically when using a higher
leverage. In other words, higher leverage ratios are linked to a higher probability to hit
a loss. The reason is that when trading with an excessive leverage, the trade may not
have enough space to draw down before it moves in the trader’s direction. The same
study revealed how retail traders were profitable 6 times out of 10 when using a
leverage ratio such as 5:1 or smaller, while they were profitable less than 5 times out of
10 when using a leverage ratio such as 25:1 or higher. These data are evidence enough
that an excessive leverage works against the trader. The following is a list of the most
common rules that professional traders generally follow.
A classic way to manage a trade is to trail the stop up or down every time a new
position is added, in order not to risk more than a predetermined amount. However,
retail traders are often confused about when it is appropriate to add a new position. The
answer is that it may be appropriate to scale into a winning position only when the
market is trending strongly, since there are no logical reasons to scale in when the
market is moving in a choppy way. Once a new position is added, it is important to trail
the stop on the previous position. In this way, the first position is at breakeven and the
risk is now pending on the second one. Another main reason why the retail traders are
not profitable is because the average account size. It is extremely important to not trade
if the account size is limited. Simply put, if the trade goes against, there is a high risk of
not having enough space to make the trade run, and as a consequence the trader can hit a
margin call. A simple data can clarify how it is important to not trade with a limited
amount of money. When trading with an average account of 1,000 $, only two traders out
of 10, turned in a profit after a year. When, on the other hand, trading with 10.000 $,
more than four traders out of 10, were profitable at one year. It is then important to
know how much should be traded based on the available capital and the number of pips
risked. The formula below is extremely useful in order to trade fair.
Position Size = (Account Size * Percent Risked) / Number of Pips Risked * Pip
Value
The next table provides an insight into the correlation between different crosses
at 10 days.
AUDUSD EURJPY EURUSD GBPUSD NZDUSD USDCAD USDCHF USDJPY
AUDUSD 100 81.6 -2.6 68.9 82.5 -79.3 -15.6 64.9 AUDUSD
EURJPY 81.6 100 11.7 81.8 54.2 -43.3 -26.1 68.5 EURJPY
EURUSD -2.6 11.7 100 14.3 15.9 3.1 -86.2 -64.3 EURUSD
GBPUSD 68.9 81.8 14.3 100 38.2 -29.7 -36.2 52.7 GBPUSD
NZDUSD 82.5 54.2 15.9 38.2 100 -85.2 -34.1 30.2 NZDUSD
USDCAD -79.3 -43.3 3.1 -29.7 -85.2 100 8 -35.6 USDCAD
USDCHF -15.6 -26.1 -86.2 -36.2 -34.1 8 100 43 USDCHF
USDJPY 64.9 68.5 -64.3 52.7 30.2 -35.6 43 100 USDJPY
AUDUSD EURJPY EURUSD GBPUSD NZDUSD USDCAD USDCHF USDJPY
The correlation may change over time, which calls for a constant evaluation. For
example, we can see a negative correlation between the EUR/USD cross and the
USD/CHF. This means that a trader could buy the Fiber, while shorting the Swissy,
allowing to reduce the risk. The table shows that it would make no sense to hedge the
Fiber with the Loonie. Once we have analyzed the most important principle of money
management, it is now time to study the differences between the martingale trading
systems and the anti-martingale systems. The martingale systems add a new position of
the same sign, to a losing trade. On the other hand, the anti-martingale systems add a
new position of the same sign, to a profitable position. The standard martingale system
takes profit on winners, doubling the exposure on losing trades; simply put, there is a
high risk that losses could run up exponentially. The reverse martingale or “anti-
martingale”, does the exact opposite. It closes losing trades, and doubles the profitable
ones. The answer to the question “which system is the most profitable” depends on the
kind of market conditions. In particular, the standard martingale works better in flat,
range bound markets, while the anti-martingale performs better with volatile, trending
markets.
In conclusion, before placing an order in the market a trader should always
know whether to adopt a classic strategy of money management or a hedging trading
strategy, being fully aware of the risks and the benefits involved in both strategies. It is
important to add that statistically the currencies tend to move in the range about 70
percent of the time. This means that applying a grid trading strategy might be profitable,
but only under the condition that a trader is able to close the open losing trades promptly
and to accept the loss in the event that the couple starts moving in a directional way. It
should also be recalled that there are no specific rules in the positioning of the stop
loss. Some of the greatest traders ever use very large stop loss, thus avoiding being
stopped out for a simple retracing.
Finally, we know where the Holy Grail is. The money management along with
the fundamental analysis are the keys we have been looking for to open the door where
the legendary cup is. Even the best indicators cannot avoid a loss. But how a trader
manage the losing trade is what can make him the CHOSEN TEMPLAR.
Only the worthy can find the Grail, Leigh. You told me that.
Akiva Goldsman, for the film The Da Vinci Code (2006) based on The Da
Vinci Code (2003)
21. Conclusions
“Money doesn’t always bring happiness. People with ten million dollars are no
happier than people with nine million dollars!”- Hobart Brown
Over this journey in our quest for the Holy Grail of Forex we debunked several
myths testing the pros and cons of different indicators and trading systems. Traders are
often attracted by the “charme” of an indicator rather than by its proven ability to
effectively interpret the markets. As Warren Buffett pointed out, it is always best to not
fall in love with an indicator but rather be able to understand what is happening in the
market at any given time. In other words, the fundamental analysis is essential to have a
strong performance. If an increase in the interest rate is foreseen in a stable economy
like the USA’s, the USD might be expected to get stronger against other currencies. In
other words, it would not be logical to short the US Dollar. It is good to remember that
is not the interest rate applied by the central bank, but the expectations on it, that move
the currency in a particular direction. It is also important to understand what is the
current prevailing sentiment in the market. In times of high volatility and falling markets,
the US Dollar and the Japanese Yen tend to be regarded as a safe haven, and
consequently they tend to appreciate. A trader should then be always aware of the
expectations on the interest rate of the countries of the underlying currency, the general
conditions of the country and the sentiment that the big investors might have about the
country under analysis. Once this initial assessment is done, it is then time to analyze the
COT report; this way the trader has a real-time overview on the long or short positions
that large investors hold. In the end, a trader can trigger a trade using the price action or
by analyzing the Bollinger Bands when the volatility is higher than the average of the
last periods. On the other hand, counter-trend trades will be opened when the volatility
is low and when the trend of the underlying currency pair is uncertain. One should never
open counter-trend trades when the underlying trend is clearly upward or downward.
The trend should be always detected on the daily, weekly or monthly time-frames and
the key is to not open a trade on the basis of a short time frame.
Ad Maiora.